MONETARY POLICY TRANSMISSION

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					Policy Research Institute of Bangladesh   1
                         I. Introduction


Observations on Monetary Policy Statement (MPS) Will Focus on
the Following Areas:

  The macroeconomic setting against which the MPS has been
issued by this Bangladesh Bank (BB);


  Monetary policy complications arising from this macroeconomic
environment.


  Can Bangladesh Bank (BB) set a monetary target if it is
targeting the exchange rate?


  Some other important specific issues regarding the MPS.



                        Policy Research Institute of Bangladesh   2
        II. The Macroeconomic Setting and
               Monetary Challenges


  Slower domestic activity, particularly in the first half of FY10.


  Larger current account surplus due to slower imports and
buoyant remittance inflows.


  Excess liquidity in the banking system, due to slower private
sector credit demand and also reflecting the sharp increase in net
foreign assets (NFA) of the banking system.


  Inflationary situation is benign, but may not stay that way if
reserve money expansion remains unchecked.




                         Policy Research Institute of Bangladesh      3
       The Balance of Payments Outlook Remains
                      Very Strong

                         Table 1. Balance of Payments

                               Balance Of Payments (US$ million)
                                              B alance of     B ala nce of
                                B alance of P aym e n t s for P aym e nt s B ala nce of
                                P aym e n t s F Y 09(Jul-       for F Y      P aym e nt s
                  It e m s       for F Y08       May)           09(e s t . ) for F Y10*
         Trade balance             -5541         -4698           -4 906         -5552
         Me rchan dis e
         e x port                  13945           14190             15542     16940
              (Growt h (%))         15. 8           11. 7             11. 5      9
         Me rchan dis e
         im port                  -19486           -18888           -2 0448    -22492
              (Growt h (%))        26. 1             7. 7             4. 9       10
         Cu rre nt Accou n t
         B alance                   672             1809              2275      2203
               (% of GD P )         0. 8             2. 0              2. 5      2. 2
         Cap it alAcco un t
         (ne t )                     576            409                460      450
         F inancial Acco unt        -431            -691              -4 90     -245
         E rrors and
         om is s ions               -213            -134              -2 70     -350
         Ove rall B alance           604            1393              1975      2058
         *P r oject ed




  It poses a new type of challenge for monetary management in
Bangladesh, not experienced before.
                                     Policy Research Institute of Bangladesh                4
       Excess liquidity in the Banking System has
       made the Interbank Market Dysfunctional


  Overnight rates have collapsed and now ranging between 0.1%-
.0.3% over a prolong period.


  BB interventions to mop up the excess liquidity have been delayed
and the efforts of recent days have been very limited.


   There is real risk that much of the liquidity will spill into the stock
market and real estate and encourage financial institutions to engage
in other speculative off balance sheet activities.

  Such developments may potentially creating other major problems
for the economy and for the viability of those institutions down the
line.

 The recent bailing out of banks in the FSU countries and Nigeria are
some such examples.
                           Policy Research Institute of Bangladesh           5
    III. Adequacy of Policy Response Through
                                   the MPS


  The MPS rightly takes note of some of these developments in
section 2 on macroeconomic outcome and outlook.


  However, the MPS makes a strange argument that since both the
overnight and treasury bill rates plummeted and “banks displayed
no enthusiasm for corresponding decline in their lending rates,
Bangladesh Bank addressed this downward stickiness of lending
rates by prescribing ceilings on lending interest rates….”


  While the MPS mentions about numerous refinance schemes, it
fails to recognize how much further liquidity BB has been injecting
through its various refinance/discount facilities and the associated
quasi-fiscal costs.




                         Policy Research Institute of Bangladesh       6
     Does the MP Framework Pass the Reality
                    Check?


  Based on the BOP projections, the NFA of the banking system is
expected to increase by $2 billion or 30.9 percent in FY10.

  Already foreign exchange reserves have increased by $0.75 billion
since end-June; and compared with January 2009, the increase in
foreign exchange reserves of BB was about $2.6 billion.


  In contrast, the monetary program underpinning the MPS,
envisages a reduction of the NFA by $0.5 billion in FY10.


  Past history of NFA growth in Bangladesh also cannot be
reconciled with this envisaged reduction in the NFA in the MPS.




                         Policy Research Institute of Bangladesh      7
                    What is the Likely Scenario?

  As shown in the BOP projection earlier, the overall BOP surplus will be
about $2 billion in FY10.

  The corresponding increase in the NFA would be about the same, assuming
no major shift in the asset and liability positions of BB.

  In that situation, the Monetary Program with the targeted 15.5% M2
expansion would be like:
                             Table 2. Bangladesh: Monetary Survey, 2008-10 (Growth Rates)
                                                                                                             FY10 Scenerio
                                                                                                   FY10
                                                                  June                                         with 16.7%
                                                                              4- Year      FY10     PRI
             Components                Jun-08       May-09      2009, BB                                       growth in
                                                                             Average      BB MPS Projectio
                                                                  MPS                                        private sector
                                                                                                     n
                                                                                                                 credit
    1. NET FOREIGN ASSETS               14.5          27.1         23.9         20.2       -4.1     30.9         30.9
    (a) BANGLADESH BANK                 13.3          31.7                      22.1
    (b) DEPOSIT MONEY BANKS             24.9          -3.1                      8.1
    2. NET DOMESTIC ASSETS              18.2          17.2         16.0         18.2       19.3     12.6         19.7
    A. DOMESTIC CREDIT (a+b+c)          21.2          17.2         17.1         19.1       18.7     12.9         18.9
    Claims on Public Sector (a+b)       10.0          17.7         24.5         20.3       25.3     25.4         25.4
    a.Claims on Govt.(net)              30.4          24.7         26.2         24.2       29.6     29.6         29.6
    b.Claims on Other Public            -32.2         -5.3         15.4         11.7        0.0     9.8           9.8
    c.Claims on Private Sector          25.2          17.1         15.0         18.9       16.7     8.6          16.7
    B. NET OTHER ASSETS                 42.7          17.6         24.7         27.3       15.4     14.4         14.4
    3. BROAD MONEY(1+2)                 17.6          18.6         17.2         18.2       15.5     15.5         21.5

                                                Policy Research Institute of Bangladesh                                       8
       Implications and Policy Trade-offs
    Underpinning the Likely Monetary Outlook


   Certainly private sector credit cannot be limited to 8.6 percent,
it has never happened and it should not happen in that way.


  Government’s current policy with respect to loss making public
enterprises does not go well with assumption of no net borrowing
by the public entities from the banking system. We do not know
how big the amount of borrowing will be, but certainly it will not
be zero as envisaged in the MPS.


  If the credit target for the private sector is to be realized, as it
should be, the expansion of broad money would probably increase
to 21.5% compared with 15.5% targeted under the program.




                          Policy Research Institute of Bangladesh        9
     We May also Pose the Question Whether BB
      Can and Does Have a Monetary Target At
                        All?


  We all know BB is targeting
the    exchange   rate   stability,
which probably it should do since
the     exchange    rate    would
otherwise              appreciate
significantly    hurting       the
exporters.


  As BB buys foreign exchange
from the interbank market in
support of this policy, foreign
assets of BB go up (Figure 1) and
so does the reserve money
expansion, unless mopped up by
BB.


                           Policy Research Institute of Bangladesh   10
      We May also Pose the Question Whether BB
       Can and Does Have a Monetary Target At
                    All? …Cont’d



  It is therefore no surprise that with the rapid buildup in foreign
reserves in recent months, reserve money expanded by more than
30% in FY09, a pace certainly not consistent with the inflation
objective.


  Since targeting money supply would entail limiting growth of
reserve money or the Net Domestic Assets (NDA) of BB, the task will
be challenging (if not impossible) and will require mopping up of
excess liquidity as part of very active monetary management
through open market operations.




                          Policy Research Institute of Bangladesh      11
      What does the MPS say about these
                   issues?
  The MPS essentially tries to bypass these issues.

  On crowding out, It simply brushes off the issue of potential
crowding out of private sector credit by the public sector, which the
Chambers and Federations are so concerned about in the aftermath of
the budget announcement.

  The MPS simply states that because every year public expenditure
program underwent substantial downsizing, requiring lower actual bank
borrowing, government bank borrowing will not crowd out private
sector borrowing needs.

  Certainly, such a suggestion goes against the much                  needed
expansionary fiscal policy stance adopted in the FY10 budget.

  Would it not be inappropriate for BB to urge the government to
implement its development plan expeditiously and intensify its efforts to
mobilize larger amounts of external budget support to help release
resources for private sector credit?
                            Policy Research Institute of Bangladesh            12
      What does the MPS say about these
              issues?...Cont’d


  On liquidity management, the MPS is almost mute.
   Certainly the task is urgent with the growing risk of excess liquidity
flowing into undesirable activities.


  Although belatedly, BB has recently announced the intention to
engage in mopping up of excess liquidity. But so far, based on press
reports, only Tk. 7 billion has been withdrawn from the money market.


  The overnight rates are still 0.1%-0.3%, well below the treasury-bill
rates, and do not indicate any serious effort toward absorption of excess
liquidity by the BB.




                           Policy Research Institute of Bangladesh          13
        What is the Downside Risk that Monetary
        Management May Become More Difficult?

  Such an outcome is unlikely, but may happen if capital inflows
continue at the pace observed in recent weeks.


  We may be looking at an NFA increase of $5 billion in FY10:

  Foreign exchange reserves have been increasing by $100 million or
so every week; and

  if that pace continues or accelerates due to continued lower import
demand or transfer of savings by expatriate workers in response to
higher return on assets in Bangladesh.

 Is BB ready for such a positive external inflow? If so how, will it
manage the resulting surge in monetary base?

  Will it give up the inflation objective or engage in a massive
sterilization program with high quasi-fiscal cost?


                           Policy Research Institute of Bangladesh      14
       What is the Downside Risk that Monetary
           Management May Become More
                   Difficult?...cont’d


 Sustainability of the current de facto pegged regime may also be
questioned if the current pace of inflows continues.

  BB foreign reserves should reach $10-11 billion within the next
couple of months after taking into account the disbursement under
the ADB Counter Cyclical Facility and budget support ($740 million)
and the SDR allocation of the IMF.


  With such an unprecedented level of foreign reserves, any major
appreciation of the Taka against the dollar may easily wipe out BB’s
capital and income base. (China syndrome to a limited extent).




                         Policy Research Institute of Bangladesh       15
      What is the Policy Package for BB Under
               These Circumstances?


  Engage vigorously in mopping up the excess liquidity and not be too
concerned about the sterilization cost. The overnight rate must not
stay below 1% level and reserve money expansion should come back
to normal levels. The eventual cost otherwise will be too high.


  Support the expansionary fiscal stance adopted in the budget, and
avoid the potential crowding out issue through mechanisms like
additional budget support from the ADB and World Bank.


  Once the export situation improves with better external market
outlook, allow the exchange rate to be more market based (if inflows
continue) even if it entails some appreciation of the Taka.




                         Policy Research Institute of Bangladesh        16
       What is the Policy Package for BB Under
           These Circumstances?...Cont’d


   The issue of high lending rates should be addressed through
financial sector reforms (including rationalization of NSS
interest rates), and moving away from interest rate ceilings in
lending to priority sectors.


  The ceilings may over time divert credit away from the
priority sectors, undermining the original objective.



  Overall, BB should focus more on its core mandate of
maintaining price stability (including asset prices) through
proactive management of monetary base and move away from
distortionary micro interventions.




                         Policy Research Institute of Bangladesh   17